Defined Contribution Plans

Conventional 401(k) Plans

401(k) Plans are popular among the companies that would like to provide a retirement plan for their employees that allow the employees to defer part of their own salary (up to regulated limits) on a pre-tax basis into the plan and contribute toward their own retirement. In general, there is no limitation as to the size a company must be in order to take advantage of the use of a 401(k) Plan.

Additionally, they can be set up to allow the employer to choose whether or not they contribute on the employees’ behalf. Typical types of employer contributions that may be included are matching contributions and/or profit sharing contributions. Employer contributions are discretionary and are flexible in terms of the different formulas that may be utilized in determining the contribution level.

Generally, there are 3 potential money types (sources) in a conventional 401k Plan; salary deferral (401(k), employer matching contribution and employer profit sharing contribution. Other money types are available provided that the plan document used supports them. (ie. IRA Rollovers, Employee after-tax contributions, Qualified non-elective contributions (QNEC) Profit Sharing Plans
Given the discretionary nature of the contribution requirements, Profit Sharing Plans are popular among businesses that may not know year-to-year what their bottom line may yield.

Typically, the only money type (source) utilized in which periodic deposits are made in these types of plans are the discretionary employer profit sharing contributions. As with conventional 401(k) Plans, other money types are available provided that the plan document used supports them.

These plans also offer plan sponsors great flexibility in determining the eligibility, vesting and loan provisions, among others, used in the plan, which allows them to tailor the plan to fit their business needs.

Due to the changes in law under EGTRRA, for plan years beginning after January 1, 2002, the limitations on contributions for profit sharing plans allow employers to make contributions up to 25% of the eligible payroll for the company. The breakdown of the contributions between the eligible employees is typically accomplished on a pro-rata basis (ie. 10% of pay to each eligible employee) unless some other advanced technique such as cross-testing is incorporated. (Cross-testing discussed below)

Profit Sharing 401(k)

Profit Sharing 401(k) Plans are just as the name implies. These plans combine the benefits of a conventional 401(k) Plan with the benefits derived from a Profit Sharing Plan into one plan, with all the same rules applying. These plans are extremely popular for the businesses that have the desire to give the employees flexibility to contribute toward their own retirement while still allowing the employer the ability to share in the profitability of the company, on a discretionary basis, as revenue allows. As with Profit Sharing Plans, advanced techniques and formulas may be incorporated to allow for greater flexibility in terms of how much an employer contributes to each eligible employee.

Money Purchase Plans

Given the mandatory nature of the contribution requirements for Money Purchase Pension Plans, historically they have been utilized by businesses that have had very consistent profits year-to-year and/or by companies that required contributions in excess of the contributions limits that used to be allowable in a Profit Sharing Plan.

Prior to EGTRRA, Profit Sharing Plans were limited to 15% of pay while Money Purchase Plans were 25% of pay. Therefore, for the companies that desired contributions in excess of the 15% of pay maximum of a Profit Sharing Plan, a second plan was put in place (Money Purchase Plan) that allowed them to contribute the additional 10% (25%-15%). However, with the advent of EGTRRA and the increase in the Profit Sharing Plan limit to 25% of pay, the Money Purchase Plan has dropped off in popularity and has all but become obsolete in most instances due to its mandatory nature for contributions and its more restrictive rules relative to the Profit Sharing Plan.

Defined Benefit Plans

Unlike the Defined Contribution Plans (DC Plans) listed above, where the plan defines the contribution that is made on behalf of an eligible employee, a Defined Benefit Plan (DB Plan) defines and promises a specific benefit that an eligible employee will receive at some point in the future, typically at retirement. This promise, or defined benefit, is determined regardless of market conditions or contribution requirements of the employer.

A major advantage to DB Plans is that an employer is allowed to tax deduct whatever contribution is required to keep the plan fully funded in order to support the benefits of the plan.

It is important to note that because of the required costs to fund the plan on a regular basis, some companies have found themselves unable to keep up with the costs associated with keeping a DB Plan fully funded. This has shown to be especially true among large corporations who have recently moved toward the discretionary plans like Profit Sharing and/or 401(k) Plans.

However, on the other side of the coin, due to the new rules under EGTRRA, DB Plans have recently become much more popular again, especially with smaller companies.

These Plans are very beneficial among businesses with owners and key employees nearing retirement age who desire larger contributions than a DC Plan will allow. This is mainly due to the fact that older employees have less time to retire than younger employees. Therefore, if the same benefit is given to both the younger employees and older employees alike, the time to accumulate that benefit is much less with the older employee, hence why the contribution for that older employee will tend to be higher, in some cases in excess of 100% of eligible compensation.

Cash Balance Plans

A cash balance plan is a hybrid, part defined benefit plan – part defined contribution (profit sharing) plan. It is a defined benefit plan (DB Plan) in that the contributions are calculated using funding methods derived from DB Plans. However, it is a profit sharing plan (DC Plan) in that the ‘defined benefit’ for a participant is converted to a ‘theoretical account balance’, a form that is generally more understandable by the general public.

This actuarially-designed defined benefit plan determines an employee’s benefit by reference to the employee’s “account balance” or theoretical account that is established using a method similar to how a profit sharing plan allocates contributions and earnings to a participant. With a cash balance plan, each employee’s theoretical account is the sum of contributions for prior plan years plus interest adjustments made to the participant’s account through normal retirement age.

One creative cash balance plan design cross-tests a participant’s contributions and account balance similar to an age-based, cross-tested profit sharing 401(k) plan. The benefit of this plan design is that selected highly compensated employees or key employees can receive an allocation in excess of the profit sharing plan limitation of $40,000 annually. Reference to the preamble to the proposed regulations for cash balance plans dated September 21, 1991 supports this view:

Preamble to Proposed Regulations, September 21, 1991.

A cash balance plan satisfies Code Section 401(a)(4) if it provides benefit accruals that are non-discriminatory under the general test for defined benefit pension plans, or if it is non-discriminatory with respect to an equivalent amount of contributions under the cross-testing rules, or if it meets a special safe harbor for cash balance plans.

Enforcement of the cash balance amended and proposed regulations have recently been suspended by the government as a result of criticism from Congress, the practitioner community, and the courts. The criticism mainly relates to plan conversions from traditional defined benefit plans to cash balance plans, though new cash balance plan Favorable Determination Letters continue to be issued by the Internal Revenue Service.

Target Benefit Plans

Target Benefit Plans are a mix between a Defined Benefit Plan and a Money Purchase Plan. This plan is designed primarily to allow for each eligible employee to have an individual account funded solely by the mandatory employer contributions made each year. The contributions are based on an actuarially generated formula or targeted benefit, similar to a Defined Benefit Plan, however, the actual benefit received when an eligible employee retires is calculated and based upon the actual balance that resides in the employee’s account at the time of retirement and not the benefit that the plan was funding for.

Optional Features

Safe Harbor

Many employers are now adopting safe harbor 401(k) or safe harbor profit sharing 401(k) plans. One of the primary reasons is that EGTRRA (The Economic Growth Tax Relief and Recovery Act) increased the maximum salary deferrals allowable while not increasing the Safe Harbor Contribution rate enacted by the Small Business Job Protection Act of 1996. The bottom line is that both the safe harbor non-elective and safe harbor matching contribution methods bring future higher benefits for highly compensated employees while at the same time continuing to provide a substantial benefit for the non-highly compensated rank & file employees.

Big companies previously using negative salary deferral elections to help satisfy the Actual Deferral Percentage (“ADP”) test have, in many cases, found safe harbor matching contributions to be a useful way to allow highly compensated employees to participate in the plan on a substantive level while keeping controls on costs .

Research has also established that smaller companies have been using the safe harbor non-elective profit sharing contribution method to eliminate the high cost of 401(k) Anti-Discrimination Testing; while satisfying the top-heavy minimum contribution requirements and maximizing contributions allowable to highly compensated employees. It is our opinion that using either method provides an efficient mechanism to satisfy ADP testing and increase benefits to highly compensated employees without adversely affecting the non-highly compensated employees.

Click here to see more regarding how the safe harbor formulas are calculated.

Cross Testing

Cross-testing, sometimes referred to as Tiering, is an advanced technique often used when employers desire the flexibility to provide different contribution formulas for different classifications of employees.

This advanced technique may be incorporated and applied to both Defined Contribution (Profit Sharing, 401(k), Money Purchase, etc.) and Defined Benefit Plans alike.

One of the most attractive features of these types of designs is that it allows the employer to design a plan that more closely meets the needs of the business. No longer are you required to allocate contributions proportionately (same % of pay to each) to all employees based on their salary. A disparity in contributions now may be designed into the plan provided that certain testing requirements are met. Employers are freer to decide how the contributions should be allocated, provided they are based on any reasonable classification. (ie. job description, years of service, salary range, department profitability, etc.)

Age Based

Code Section 401(a)(4) allows testing of a defined contribution (DC) plan (profit sharing 401(k), money purchase, and target benefit plans) for discrimination on a benefits basis. This allows a plan sponsor to take into consideration when allocating contributions, a participant’s age and salary. The underlying premise is that a younger participant receiving the same contribution as an older participant is actually getting a greater benefit than the older participant since the contribution made for the younger participant will, at normal retirement, have had the opportunity to compound longer since it is a longer period of time until they reach normal retirement age. Based on a one percent of paid benefit, this method provides for contributions based on age and pay that are non-discriminatory. The age-weighted plan is a non-safe harbor plan and is tested yearly for non-discrimination using the Code Section 401(a)(4) general test.